Academic journal article Review - Federal Reserve Bank of St. Louis

The Changing Role of the Federal Reserve

Academic journal article Review - Federal Reserve Bank of St. Louis

The Changing Role of the Federal Reserve

Article excerpt

When I went to Washington in 1979, most people thought the Federal Reserve was either a bonded bourbon or a branch of the National Guard. In those days, stabilization theory, which is an economist's way of saying steady growth, was based on changeable fiscal policy and steady monetary policy. The Fed was a low-profile institution. Milton Friedman was the most visible of the monetarists, and he went so far as to say that we might even be able to do away with the Federal Reserve. He wanted to put monetary policy on autopilot, and he regarded fine-tuning as the worst possible option. Now we have a system in which there is almost universal agreement that we ought to have a budget that is in surplus and a Federal Reserve that should be flexible in monetary policy in order to respond to changes in the economy. To Milton Friedman's consternation, Alan Greenspan is the greatest fine-tuner in history. We have come a full 180 degrees in the past 20 years.

Why did that happen and what kind of an organization is the Federal Reserve? A little history. In 1913 the Federal Reserve was created, primarily to respond to financial panics. In rural areas, the agricultural banks would be fully committed to commodity loans. Sometimes there would be a sharp drop in prices and people would want to take their deposits out of the banks. The banks would call their loans, farmers would fail, there would be a run on the banks, and both farmers and bankers would be bankrupt. The Federal Reserve was created as a lender of last resort so that the banks could borrow from the Fed until prices stabilized. In the urban centers, excessive speculation in financial markets sometimes caused short-term distress. Again, the Federal Reserve could provide the banks with liquidity until prices stabilized. The system worked reasonably well for several years, including 1921, when we had a sharp drop in commodities.

But when the Great Depression hit in 1929, a combination of errors in judgment and structural flaws prevented the Fed from adequately responding. Structural problems were threefold. First, the Treasury secretary sat on the Federal Reserve Board, so decisions were politicized. Second, the nation was on the gold standard, which required the Federal Reserve to be shrinking the money supply during a time when it should have been increasing it to fight deflation. Third, the Federal Reserve did not have authorization to buy and sell in the open market, a capability used to steady the money supply. I remember that one of the first shocks that I had after getting on the Board was related to open market operations. Every Monday the staff at the New York Fed and the staff in Washington did (and still do) their calculations to come up with an agreement on how much money needed to be injected into or removed from the system. I had been on the job for a week when they made the request to pump $3 billion into the market. That was the first $3 billion decision I ever had to make.

The National Banking Act of 1935 fixed the structural problems but still required the Federal Reserve to buy any bonds that were issued by the federal government, with the result of monetizing the debt. This inflationary threat was changed by the Treasury Accord of 1951. Since that time, the Fed has had a high degree of independence.

What kind of organization is the Federal Reserve? There are about 25,000 employees. Policymaking is the exclusive domain of the seven members of the Board of Governors in Washington. They are all appointed by the President and confirmed by the Senate. The Chairman and Vice Chairman are confirmed separately, first as Governor and then as Chairman or Vice Chairman. There are about 1,500 employees in Washington. One of my responsibilities was as the administrative governor in charge of the Washington staff.

There are 12 Federal Reserve Banks and more than 40 branches. Most activity at these institutions involves clearing checks and acting as the fiscal agent for the government, primarily selling bonds and accepting various kinds of government deposits. …

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